Bonds 101 – Risks & Strategies

The bond market is by far the largest securities market in the world, providing investors with a virtually limitless investment option. Many investors are familiar with aspects of the market, but as the number of new products grows, even a bond expert is challenged to keep pace.

What is a bond?

A bond is a debt security and is a form of borrowing. Governments and companies issue bonds to raise funds from investors willing to lend them money for a period of time. Investors, including retail investors, buy bonds to earn interest during the life of the bond. Bonds can form part of investors’ investment portfolios.

You can think of bonds as a loan, with the investor making the loan. When you invest in a bond, you loan money to an ‘issuer’, such as a corporation or the government, which needs it to fund business growth or meet immediate spending needs.

In return, you receive regular income payments in the form of interest, just like the interest on a loan, except you’re the bank and you receive interest rather than paying it.

Bonds are issued for a set period and when that period expires – in other words when the bond reaches its ‘maturity’ – the issuer promises to repay the face value of the bond. Once issued, bonds can be traded and their prices fluctuate. However, when a bond reaches its maturity, the holder of the bond will receive the face value of the bond.

Always remember that the value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Where do bonds come from?

Governments

Governments around the globe issue bonds to fund government spending or to cover budget deficits.

Companies

Companies also issue bonds. These provide credit to help finance a variety of operations, as an alternative to a bank. Corporate bonds tend to be safer when issued by reputable companies and riskier when issued by weak companies. As a result, financially stronger companies can issue bonds that pay less interest than those offered by financially weaker companies.

The risk in investing bonds

Bonds are generally considered less risky than equities because their prices tend to be less volatile, but as with any investment, there is always some risk involved.

Interest rate risk

A bond’s price generally decreases when interest rates rise and increases when interest rates fall. The longer a bond’s maturity, the higher the risk of significant fluctuations in its price caused by changes in market interest rates.

Income risk

Income from bond funds may fall because of declining interest rates. If you need income to pay for living expenses, you should expect it to fluctuate because of changes in bond yields. Income risk is higher for short-term bond funds and lower for long-term bond funds.

Inflation risk

The risk that the income paid by a bond will decline in real terms because of rising prices. The inflation risk is highest for short-term bonds, medium for intermediate-term bonds and relatively low for long-term bonds.

Currency risk

Fluctuations in the value of the pound and foreign currencies can seriously affect the returns from overseas investments. A weaker pound can increase the value of foreign holdings, which would benefit a British investor. However, if the value of the pound rises the value of those foreign assets will fall.

Some bond funds are actively managed, which means professional fund managers try to pick a mix of bonds that will deliver returns that are better than a given benchmark. Others are ‘passive’ or ‘index’ funds which seek to track the performance of particular bond market benchmarks.

A bond investment fund pools money from many investors to purchase a diversified selection of bonds. Bond funds come in several ‘flavours’, investing in the different types of bonds described previously in different mixes and levels of credit quality.

A bond’s credit rating reflects the rating agency’s opinion of the issuer’s ability to pay interest on the bond and, ultimately, to repay the principal at maturity. If payments aren’t made in full and on time, the issuer has ‘defaulted’ on the bond.

Bond rating codes explained

Asset class

Moody’s

S&P

Rating

Investment- grade bonds

Aaa

AAA

Highest quality with the lowest risk; issuers are exceptionally stable and dependable.

Bond investing strategies

Bond investors can choose from many different investment strategies, depending on the role or roles that bonds will play in their investment portfolios.

Passive strategies — Buy-and-hold approaches: Investors seeking capital preservation, income and/or diversification may simply buy bonds and hold them until they mature. The interest rate environment affects the prices buy-and-hold investors pay for bonds when they first invest and again when they need to reinvest their money at maturity. Strategies have evolved that can help buy-and-hold investors manage this inherent interest rate risk. One of the most popular is the bond ladder.

Other passive strategies: Investors seeking the traditional benefits of bonds may also choose from passive investment strategies that attempt to match the performance of bond indexes. For example, a core bond portfolio in the U.S. might use a broad, investment grade index, such as the Barclays U.S. Aggregate Index, as a performance benchmark, or guideline. Similar to equity indexes, bond indexes are transparent and performance is updated and published daily.

Active strategies: Investors who aim to outperform bond indexes use actively managed bond strategies. Active portfolio managers can attempt to maximise income or capital (price) appreciation from bonds, or both. Many bond portfolios managed for institutional investors, many bond mutual funds and an increasing number of ETFs (exchange-traded funds) are actively managed.

One of the most widely used active approaches is known as total return investing, which uses a variety of strategies to maximise capital appreciation. Active bond portfolio managers seeking price appreciation try to buy undervalued bonds, hold them as they rise in price and then sell them before maturity to realise the profits. Active managers can employ a number of different techniques in an effort to find bonds that could rise in price.